The Uncertain Future of GameStop (GME)

Last week, GameStop (GME: Charts, News) shares fell after the video game retailer announced unimpressive fourth quarter earnings, revealing major problems with its business model. The company posted non-GAAP earnings of $1.73 per share on revenue of $3.58 billion. Analysts had expected earnings of $1.73 on the same basis, on revenue of $3.69 billion.

While the company matched expectations on non-GAAP earnings, GAAP-adjusted earnings fell sharply, down 19% from the prior year quarter's $1.56 per share. The 3.1% slide in revenue from the previous year's $3.69 billion also alarmed investors. Meanwhile, gross and operating margins rose while net margins shrank. For the full year, the company's net earnings dropped to $340 million from $408 million in fiscal 2010. Earnings rose slightly from $9.5 billion to $9.6 billion.

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GameStop has been shifting its business rapidly toward digital distribution channels - the high margin segment that large publishers such as Activision Blizzard (ATVI: Charts, News) and Electronic Arts (EA: Charts, News) are earning most of their profits from. GameStop's shift has been slow and expensive, but it is working - the company reported 57% year-on-year growth in its digital distribution segment, which provides retail games, downloadable content (DLC) and other digital services for customers via the Internet. Digital sales now account for 40% of the company's quarterly profits. GameStop CEO Paul Raines stated that he expects that percentage to increase in 2012. The entire digital games market is forecast to be worth $39 billion by 2014. Raines has stated that GameStop's goal is to control at least $1.5 billion of the market by that time.

Raines also announced a new partnership with Activision Blizzard, the publisher of hit titles Call of Duty, World of Warcraft, Starcraft and Diablo, to increase its available digital content, in the form of retail games and virtual goods. Activision has already contributed heavily to GameStop's sales. GameStop made $21 million selling digital subscriptions to Activision's Call of Duty Elite subscriptions last quarter. In May, Activision will release the long-anticipated Diablo III, which will likely be a major hit for the publisher as well as GameStop's digital segment.

While digital revenues and profits are a major strength, the company's used game sales are becoming a liability. Used game sales currently comprise 46% of the company's quarterly profits. Major hardware manufacturers such as Sony (SNE: Charts, News), Microsoft (MSFT: Charts, News) and Nintendo have announced plans to link purchased games to a single console or account, preventing sharing and forcing customers to buy new copies rather than a used ones. The plan, which has received support from major studios and publishers, would instantly wipe out the entire used game market for the next generation of games. Raines claims that these fears are overrated, and that "great relationships" shared with console companies would discourage such a drastic change. However, persistent rumors have kept investors at bay. Analysts believe that if GameStop loses its used games market, it will have to double its digital business to 80% of quarterly profits within the next year - a nearly impossible growth trajectory.

GameStop shareholders can breathe a sigh of relief - for now - since the next generation of consoles isn't slated to arrive until 2013 at the earliest. However, the lack of new hardware and the apparent exhaustion of new, innovative peripherals - such as Microsoft's Kinect and Sony's Playstation Move - may dent consumer interest.

Analysts also state that the rise of smartphone and tablet based "casual" games, which are produced for far less than "triple A" multi-million dollar titles, is likely to steal market share away from traditional console-based video games. This could alter the business structure of digital sales as well, as publishers roll out free games with virtual goods which can be purchased via "micro-payments". Zynga (ZNGA: Charts, News) and Electronic Arts (EA: Charts, News) are currently the leaders of this pack of casual social games, an area where GameStop's partner Activision Blizzard is curiously absent.

On a fundamental basis, GameStop looks undervalued, trading at 6.9 times forward earnings with a 5-year PEG ratio of 0.91. On a technical basis, the stock is heavily shorted, with a short float of 40.9%, and any good news could cause a massive short squeeze and a short-term uptrend. In the long term, GameStop not only depends on the fickle growth of the video game industry, but on the rapid growth of its digital distribution channels as well as its ability to cooperate with content partners in the next generation. That's a lot of variables to get right, but GameStop looks like it can at least escape the dire fate of fallen video rental icon Blockbuster.

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Published on Mar 27, 2012

By Leo Sun

Leo Sun is a freelance finance writer and position trader. He focuses on a combination of value and momentum investing, with a strong interest in the trading philosophies of Warren Buffett and Peter Lynch. Leo also has experience writing articles to help small business owners acquire loans and manage their finances. He regularly contributes to the Stock of the Day analysis.